Long Haul Ahead for Britain's Struggling Economy

When the financial crisis began to spread five years ago, British coffee machine-maker Fracino raced to get ahead of it.

From the firm's base in Birmingham, it carved out new markets in the Middle East, Asia and even Italy for its cappuccino and espresso machines which it proudly stamps with the British flag.

Last year Fracino generated 25 percent of its turnover abroad, up from just 2 percent before the crisis.

That is the kind of transformation the Conservative-led government promised for the broader UK economy as it took office in 2010, after the near collapse of the country's huge banking sector and the plunge in housing prices.

But in the last few months, things have taken a worrying turn at Fracino. Clients at home and abroad have started to demand its cheaper machines, shunning the more expensive models and slowing the company's revenue growth.

"They are just buying the machines that will do the job," said managing director Adrian Maxwell. "Until something happens for people to take their foot off the brake and feel a little bit more relaxed about spending again, it's long going to be a long, hard haul."

Nearly three years after Britain's Conservative-led government vowed to restore the country to financial health with a round of deep spending cuts, the economy looks stuck in a rut and could already be in its third recession since 2008.

Public debt is set to carry on rising for another three years, a blow to the ruling coalition facing parliamentary elections in 2015 and which has made austerity the centerpiece of its economic policy.

The creation of more than 1 million jobs in the last two years has surprised economists. But paltry wage growth for most wage-earners has been the price of higher employment.

And the ambitious-sounding plans of 2010 to rebalance the economy with a focus on exports as a new driver of growth have so far come to little, hampered by the economic crisis that has hammered Britain's main trading partners in Europe.

Even with a 20 percent slide in the value of the British pound since the onset of the financial crisis in 2007, Britain's share of world exports has fallen by about 6 percent since then, according to data from the Organization for Economic Cooperation and Development.

"What is really striking about the UK is that it has had a quite important depreciation of the pound and still it hasn't had a big increase in exports," said Christophe Andre, an economist with the OECD.

Only Italy had worse overall growth among the industrialised Group of Seven nations in the same period, he said.

Moody's Sees Slow Growth

The Feb. 22 downgrade of Britain's triple-A rating underscored how long the economic gloom will probably last.

Moody's said it expected sluggish growth would stretch into the second half of the decade, offering the coalition government little hope of a pickup before the elections.

Forecasts used by the government predict the economy will grow by 1.2 percent in 2013 and 2 percent next year.

But estimates like that have routinely proven too optimistic. A year ago, the same official forecasters were predicting the economy would grow 2.7 percent in 2014.

A Reuters poll of private-sector economists last month predicted growth of 1.6 percent next year, better than the 1 percent growth forecast for the euro zone and only a touch slower than the forecast for Germany, but worse than the British government expects.

Not only did the economy shrink slightly in the last three months of 2012 but investment by businesses fell by 1.2 percent, a potential warning sign of more weakness to come. Factory activity shrank sharply in February, data showed on Friday.

"The optimistic view is that everything plays out nicely and we get back towards trend rates of growth. But there are structural factors pulling down on growth and they aren't going away," said Philip Rush, a UK economist with Nomura.

He thinks British gross domestic product will grow by just 0.4 percent this year by and 0.8 percent in 2014, held back in large part by the country's banking sector.

The fragile state of the country's banks mean many are too weak to resume significant amounts of new lending.

"Most people, when pushed, acknowledge that the problems in the financial sector aren't going away, but they are not factored in," Rush said.

Looking Abroad for Funding

Getting a loan is something many UK businesses say remains far too hard, despite official programs to boost lending such as the Bank of England's Funding for Lending scheme.

One of Britain's oldest manufacturing firms, Hayward Tyler Group, which makes specialist pumps and motors the size of small cars for use in power stations around the world, grew so frustrated with its bank last year it turned instead to a strategic investor in India. It provided the funding support needed for expansion in India's booming market and beyond.

Ewan Lloyd-Baker, chief executive of Hayward Tyler, said it was encouraging that manufacturing and exports were back on the political agenda, and an export credit guarantee scheme was starting to reach small companies. But the official programs move too slowly to get lending flowing again.

"In our experience, you're lucky if it's months, and it's more likely to be years," he said.

Rather than attempt a U-turn and agree to a big increase in public spending, Prime Minister David Cameron and his finance minister George Osborne are sticking to the austerity plan.

Osborne is expected to offer only small growth measures in his next budget due on March 20 and resist calls to borrow more to fund new infrastructure. Business leaders want less spending on welfare to free up funds for projects such as house-building and road repairs which could give a quick boost to growth.

The hope for Cameron and Osborne is that voters in 2015 will continue to pin at least some blame for the weak economy on the opposition Labour party. It left the country with a record peacetime budget deficit when it lost the elections in 2010.

With little additional spending expected from the government, the Bank of England is bearing the weight of expectations that it can do more to prop up the recovery.

The 375 billion pounds it has already spent on government bonds is equivalent to 22 percent of the UK's gross domestic product, nearly double the same measure of the U.S. Federal Reserve's $2.5 trillion of bond-buying to date, according to a study by the conservative Centre for Policy Studies.

The prospect of more money-printing by the BoE - and signs that the central bank will tolerate the inflationary impact of a weak pound as a price to get Britain growing again - has helped push sterling to its lowest level against the dollar since mid-2010 and a 16-month low against the euro.

Enough of Waiting

With yields on 10-year government bonds hovering around 2 percent, less than inflation, some investors have had enough.

The Templeton Strategic Bond Fund focuses on UK clients but has sold all its British government gilts after its managers decided that they looked too expensive.

"We basically think that the UK will have slow to no growth over the next couple of years while it goes through this fiscal adjustment whereas we think that emerging markets offer much better opportunities," said David Zahn, the fund's manager.

Although the fund is small with 7 million pounds under management, the shift away from gilts was reflected in other, larger ones managed by the firm which is part of U.S. investment group Franklin Templeton, Zahn said.

Other investors are taking a more aggressive stance against Britain.

After mostly betting at the start of the year that the pound would rise in value, speculative investors have reversed positions sharply with most expecting it will fall, according to data from the U.S. Commodity Futures Trading Commission.

Sterling could weaken as far as $1.40 from about $1.50 now, according to analysts at banks such as UBS and Commerzbank. Some fear a bigger fall that could push Britain's inflation higher.

It remains to be seen if weaker sterling will help bring about the long hoped-for rebalancing of the UK economy.

OECD economist Andre said Britain was simply not producing enough of what the world wants, especially developing countries hungry for the higher-end goods that represent the best hope for manufacturing in the more traditional economic powers.

Between 2005 and 2011, UK production of high-tech goods fell on average by 0.7 percent a year, contrasting with growth of 3.3 percent for the European Union as a whole, according to the European Union's statistics office.

The only other European countries to see a fall in high-tech production were Greece, Portugal and Italy.